The global banking system is under renewed pressure after the Swiss government-brokered takeover of Credit Suisse by its larger rival UBS, after the deal wiped out the investment of bondholders who owned about $17bn (£14bn) of risky Credit Suisse debt.
What has happened?
The latest fears centre on a type of bank debt introduced after the 2008 financial crisis, which had been designed to increase banks’ safety buffers, while tackling the “too big to fail” risk that they might need government support in a crisis.
Known as additional tier 1 (AT1) bank debt, the bonds are designed to convert into equity when a lender runs into trouble.
In the takeover of Credit Suisse, the Swiss Financial Market Supervisory Authority (Finma) said the deal would trigger a “complete writedown” of the value of all of the bank’s AT1 bonds – meaning the bondholders would lose all of their investment.
This has spooked markets and sparked a sell-off in other bank debt, as investors scramble to assess whether the same could happen for their holdings of AT1 debt in other banks, in a market worth more than $275bn.
What is AT1 bank debt?
Given their pivotal role as the providers of finance to millions of households and businesses, banks are heavily regulated – including rules on how much money they should set aside to absorb potential losses.
To do this, banks hold a certain amount of capital – essentially money raised from shareholders and other investors, as well as any retained profit – to serve as a shock absorber in times of stress.
Under the rules, ramped up since the 2008 financial crisis, banks hold several different levels of capital split into tiers – a bit like a wedding cake.
At the very top is common equity tier 1 capital, which is the primary source of bank funding, drawn from shareholders’ equity and retained earnings.
The next layer down is AT1 capital, which typically consists of hybrid bonds. AT1 bonds – sometimes known as contingent convertible bonds, or CoCos – are a type of debt issued by a bank that can be converted into equity if its capital levels fall below requirements. This helps to reduce debts, while handing the bank a capitalisation boost.
They were introduced after the 2008 crash as a way to “bail in” failing banks – as opposed to a taxpayer-funded bail out – by imposing losses on investors. Because of this, the bonds are riskier to hold, and investors are offered a higher return to own them.
Beneath this is tier 2 capital, which can include subordinated debt – bonds that rank behind senior debt and ordinary depositors.
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What was the problem at Credit Suisse?
The big row over Credit Suisse’s takeover centres on hierarchy: who should lose out first when a bank struggles. On the one hand, investors who bought risky AT1 bonds should expect to lose money when a bank runs into trouble.
However, there are questions because Credit Suisse’s shareholders will not be wiped out completely but are set to be compensated in the emergency takeover with UBS shares worth the equivalent of Sfr 0.76 (£0.67) a share.
Typically when a company goes bust, bondholders rank before shareholders in the creditor pecking order for any recoveries that can be paid. Although expecting to rank behind conventional bondholders in order of priority, owners of the AT1 bonds still thought they would place before equity investors.
What happens next?
In the case of the Credit Suisse, bond documentation shows that Swiss regulators held the right to upend the usual hierarchy. However, investors still fear that a precedent could be set, which would push up the cost of AT1 debt in future.
“There will need to be further premium for those securities, at least in the current environment,” said Jerry del Missier, a former chief operating officer of Barclays who is now chief investment officer at Copper Street Capital.
“The message has clearly been sent that if a bank appears to be in trouble – and the definition of trouble now includes ‘loss of confidence’ in addition to solvency and liquidity considerations – AT1 holders will immediately price in a high probability of resolution.”
Attempting to calm the market rout on Monday, other European regulators issued statements saying that owners of AT1 debt would only experience losses after shareholders have been wiped out – unlike what happened at Credit Suisse.
The European Central Bank and the European Banking Authority said equity instruments would be the first to absorb losses, and only after their full use would AT1 debts be required to be written down. “This approach has been consistently applied in past cases and will continue to guide the actions of the SRB and ECB banking supervision in crisis interventions.”
The Bank of England said that AT1 bonds rank before the highest tier of equity capital, while adding: “Holders of such instruments should expect to be exposed to losses in resolution or insolvency in the order of their positions in this hierarchy.”
